Wednesday, June 13, 2007

Crying Wolf or Crying Uncle

For a country founded on rugged individualism, our current state of affairs is looking a lot less rugged and a lot more dependent. With a massively expanding debt to foreign creditors, and an insatiable appetite for energy, we as a nation become more dependent each and every day. Even if we eventually import fewer Chinese products, the trade deficit may march higher because the percentage of energy (crude, natural gas, and refined products) from overseas sources continues to grow. More ominously, if we are in fact nearing the front door of Peak Oil, the price of energy will be headed in one direction, higher. This will only exacerbate our trade deficit.

Asian demand rising

It’s a tight box we find ourselves in at this stage in history. If Americans conserve and use less energy, they would expect prices to drop. But we live in a time of the greatest Industrial Revolution on record, with China and India coming of age simultaneously. These two countries represent 2.4 billion people, or 40% of the world’s population. The Chinese and Indians are industrializing at a furious pace, and their demands for natural resources, particularly energy, will continue rising for decades. The price of energy is set on world markets, not local markets. So as global demand continues, the price will rise in the US, no matter how frugal we become. Further, Americans will only conserve to a point. They still have to get to work, so belt tightening may have to come from other areas of the family budget.

Mark Kiesel of Pimco made some important observations on rising global demand in an article entitled “Got energy?”

“Demand for energy is also set to take off throughout most emerging market countries. This will materialize when consumer spending naturally picks up as young populations mature and already pent-up demand for consumer durables, such as automobiles and housing, continues to rise. For example, in China, auto sales are growing faster than 20% annually. By the end of the decade, the IMF projects China will be the second largest auto market in the world, with 8 million new car sales per year, compared to 17 million currently in the U.S.

As China and other emerging markets industrialize, the secular increase in demand for energy will only intensify due to these countries’ rising dependency on energy-intensive manufacturing as their main source of economic growth. With respect to growing demand for energy, the U.S. Department of Energy in March of 2005 said simply, ‘The world has never faced a problem like this.’”

Awaiting a Crisis

When the price and availability of energy reaches a crisis stage that must be faced head on, American innovation will help set us on the course toward a new age of alternate energy creation. Unfortunately innovation takes time and resources. In the interim, the process of innovation won’t move the trucks, cars, trains, planes and ships that underpin our economy and way of life. The transition to a mixed energy economy may prove uncomfortable and longer than we hope.

The problem is we must await a crisis to get started. We lack the political will and vision to look over the horizon and realize the time to start is now. Political decisions are made according to election cycles, and unless we face a severe energy crisis, nothing will happen. Energy dependence took decades to reach this level, and becoming independent again will take decades as well, along with some good fortune.

Why is energy dependence a bad thing? Japan is totally energy dependent and they seem to adjust to rising prices. The difference is Japan is a creditor nation, the US is not. Japanese citizens save a large percentage of their income. Japan runs a large trade surplus. They also have a small military and rely on the US for protection. Japan has over $900 billion in foreign reserves, and has the flexibility to deal with higher prices of energy. However, once we reach Peak Oil and global shortages apply, then Japan will have serious issues. They would be wise to follow China’s lead and begin building nuclear power facilities as rapidly as possible.

Japan is also not a super power, fighting for global influence. The US has joined China in a race for securing energy resources outside our boarders. As we become more energy dependent, our power and influence become more dependent on our ability to access foreign sources of energy. This has been written on extensively, but it is clear that the road to future global conflicts begins with energy. And as world demand inexorably increases over time, the conflicts will increase as well. This does not bode well for energy-dependent America.

Do deficits and reserves matter? Perhaps not today, but a nation living beyond its means must eventually pay the piper. The important questions are when and how much?

Credit Dependence

With increasing energy dependence and a shrinking industrial base, we are not the self -sufficient nation of 30 years ago. We are creating trillions of dollars to pay for entitlement programs that are mushrooming with an aging population and an expanding government sector. We are financing an incredibly expensive war (off-budget of course) by simply printing the money.

Every government needs checks and balances to survive. Without a gold standard to force spending restraint, government spending has accelerated well beyond the means to pay for it. The government must borrow roughly 2.5 billion dollars every day from foreign sources to keep the lights on, and that figure has been steadily rising for years.

Unfortunately, the checks and balances our government faces now come from overseas. We are increasingly dependent on foreign sources of capital. If foreign central banks determine that their trillions of US dollar reserves are at risk of significant devaluation, the money may flow elsewhere, even if it damages their exports temporarily. This is already beginning to happen as China and Middle Eastern countries look to diversify.

Global Money Printing

One plus for the dollar is that many other countries are printing money at an even faster rate, which would help the dollar retain its relative value, except against gold. So there is the possibility that compared to other fiat currencies such as the euro and British pound, the dollar could even strengthen as it inflates. Gold will remain as the sole canary in the inflationary coal mine.

Global interest rates are now starting to rise, including treasury rates. As global debtors, US debt payments will go up as well. This will ultimately mean more debt creation to pay a higher debt service, putting additional pressure on the dollar.

The relationship between supply and demand is a basic economic truth that hasn’t wavered over the centuries of recorded history. Create too much of something and its value goes down. The endgame for all this dollar creation leads in one direction; more inflation.

“The financial press sometimes criticizes Federal Reserve policy, but the validity of the fiat system itself is never challenged. Both political parties want the Fed to print more money, either to support social spending or military adventurism. Politicians want the printing presses to run faster and create more credit, so that the economy will be healed like magic, or so they believe. Fiat dollars allow us to live beyond our means, but only for so long. History shows that when the destruction of monetary value becomes rampant, nearly everyone suffers and the economic and political structure becomes unstable."

Until that fateful day when our country adopts a true “pay as you go” system, expect inflation to filter into every aspect of our lives. When one looks at the supply of paper money growth globally compared to the growth in the annual gold supply, one has to believe inflation is here already, but held in check for now by foreign central banks holding onto our dollars.

Seeking Shelter

A more dependent nation requires that investors be more informed and independent to seek out opportunities that present themselves. An independent investor (and citizen) does not panic or become morose. If you believe that real supply and demand factors will ultimately prevail in the markets, then one should not only expect inflation, but invest according to that expectation. As the trillions of depreciating dollars held by foreign central banks and other foreign sources are repatriated (slowly or otherwise), tangible assets will be back in vogue again as the herd desperately seeks a store of value. All the asset classes that were hot in the 1970’s; energy, precious metals, collectibles and real estate, will very likely return for an encore on center stage.

One may think that energy and metals have had a nice run and it’s about over. However, thanks to our friendly foreign central banks funding our debt and keeping their reserves in US treasury bonds, inflation has remained muted relative to the 1970’s. As more dollars are created to feed the insatiable debt structure, the dollar continually loses purchasing power. As it becomes more obvious that no change in policy is forthcoming or even possible, the foreign central banks may just decide to divest themselves of dollars at a more rapid pace. Or perhaps one small central bank will seek the exit door all at once to get out before the others, setting off a dollar crisis. Tangible assets are still an afterthought today because inflation is still in the box. In 1980, the S&P 500 Index was 26 % energy-related at its peak. Today, even after the huge move in energy the last few years, the S&P 500 Index sector weighting for energy is 10.2 %.

Energy and credit dependence are growing challenges that will eventually test us as a nation. We are a resourceful people, but solutions may not be easily found. As individual investors, it is not unpatriotic to seek shelter from the US dollar. If brilliant investment minds such as Warren Buffett and Bill Gross are seeking protection from a depreciating dollar by looking at tangible assets and overseas currencies for diversification, perhaps the rest of us should consider following their lead.

Today’s Markets

The Dow Jones Industrial Average finished nearly flat at 13,424.96, up .57. Other stock indicators were also essentially flat for the day. The Standard & Poor's 500 index advanced 1.45 to 1,509.12, and the Nasdaq composite index lost 1.39, to 2,572.15.

Oil prices, which also stirred inflation concerns last week, rebounded Monday after falling sharply Friday. Iran's oil minister said Monday the Organization of Petroleum Exporting Countries doesn't plan to release more oil into the market ahead of its next policy meeting in September. Light, sweet crude rose $1.06 to $65.82 per barrel on the New York Mercantile Exchange.

Amid an absence of economic and earnings reports, investors will likely focus on moves of individual stocks as they await data on inflation due later in the week. On Thursday, the Labor Department releases its producer price index and on Friday the consumer price index is due.

Gold futures rallied Monday, breaking a five-session losing streak, as physical demand, technical buying and rising crude-oil prices boosted the precious metal. Gold for August delivery closed up $8.70 at $659.0 an ounce on the New York Mercantile Exchange.

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